In February, Standard & Poor's warned that it expected U.S. corporate credit quality to deteriorate rapidly in 2009, and added that it expected recoveries against borrower defaults will be lower than historic norms. It is also very likely that the standard deviation around that average recovery will be much greater than in the past. As such, careful analysis of each credit is of paramount importance.
Several fundamental factors support the expectation for reduced recovery rates.
First, the sheer amount of debt that existed on corporate balance sheets prior to the credit crunch greatly exceeded the leverage seen in previous cycles, as seen in Figure 1. In general, leverage multiples increased approximately 1.2 times in the recent cycle. This increase might not appear large, but when one considers that the leverage multiple increased based on peak EBITDA, the multiple understates the actual increase.
Second, the structure of bank loans underwritten from 2005 through early 2008 resulted in a large amount of second lien and “covenant-lite” loans. In such cases, the inability of lenders to get “an early seat at the table” when the borrower's operating performance has weakened substantially can impact recoveries. Instead of protecting their collateral, lenders — without any recourse under the credit agreement — may watch companies sell assets to generate cash to pay maturities of unsecured creditors, make interest payments to subordinated lenders and/or draw down critical cash reserves.
Third, lenders' appetite and capacity for providing debtor-in-possession financing has diminished in the current climate, leading holders of senior secured debt to provide DIP funds. Lyondell Chemical Co., which filed for bankruptcy protection in January, is a good example. The senior lenders to Lyondell who provided a DIP loan are insisting on tighter control of the reorganization process and, by implication, a better bargaining position at the table.
Fourth, the equity cushion that existed prior to the credit crisis has largely disappeared, leaving high-yield bond investors, who rank below providers of leveraged loans and other senior debt, very exposed. From January 2000 through March 2009, the S&P 500 traded at an average total enterprise value/EBITDA multiple of 10.4 times. The current value is around 7.5 times. These lower multiples have led to little or no equity protection, translating into weaker loan-to-value ratios for credit investors.